Profit, Rent,

1
Profit, Rent, Interest
2
Sources of Economic Profit

• reward for assuming uninsurable risks
• (for example, unexpected changes in demand or
  cost conditions)
• reward for innovation
• monopoly profits

3
Transfer Earnings

• the amount that an input must earn in its
  present use to prevent it from transferring to
  another use.

4
Rent

• the difference between what an input is
  actually paid and its transfer earnings

5
Example Suppose you are willing to do a job as
long as you are paid at least 8 per hour, and
you are getting paid 10 per hour.

• What are your transfer earnings?
• 8
• What is your rent?
• 10 - 8 2

6
Example Suppose an input is earning 10 per
hour, but would be willing to do the job without
pay.

• What are the transfer earnings?
• 0
• What is the rent?
• 10 - 0 10 (All of its pay is rent.)

7
Capital

• also called physical capital.
• a factor of production.
• examples buildings and machines.

8
To purchase capital, you would probably need to
borrow funds. What does the market for loanable
funds look like?
9
Demand for loanable funds

• People borrow less if the price of the funds is
  high. (The price of the funds is the interest
  rate.)
• So, there is an inverse relation between the
  interest rate and the quantity demanded of
  loanable funds.
• So, the demand curve for loanable funds slopes
  downward.

10
Demand for loanable funds
interest rate
D
loanable funds
11
Supply of loanable funds

• People are willing to lend more money if the
  interest rate is high.
• So, there is a direct relation between the
  interest rate and the quantity supplied of
  loanable funds.
• So, the supply curve for loanable funds slopes
  upward.

12
Supply of loanable funds
interest rate
S
loanable funds
13
Combine the demand for loanable funds and the
supply of loanable funds.
interest rate
S
D
loanable funds
14
The equilibrium quantity of loanable funds and
the equilibrium interest rate.
interest rate
S
i
D
Q
loanable funds
15
real rate of interest

• money rate of interest - inflation rate
• If the money rate of interest is 7 and the
  inflation rate is 3, what is the real rate of
  interest?
• real rate of interest 7 - 3 4

16
Why are there different interest rates?

• differences in costs of processing
• It costs more to process a 100,000 loan than
  a 10,000 loan, but not ten times as much.
• differences in risk
• Will the loan be paid back on time and in
  full? Some people are riskier than others.
• different loan durations
• conditions such as the inflation rate may
  change during the period of the loan

17
Components of the Money Interest Rate

• inflation premium
• cost premium covering processing and risk
• pure interest - price of earlier availability

18
The pure interest componentPeople are willing
to pay to get money now rather than wait until
later because...
19

• 1. People prefer to have goods now rather
  than to have to wait for them.

20

• 2. People can use the money to buy something
  that will increase their productivity, so they
  can make more later.

21
Compounding
22
Suppose you put 100 in the bank with an annual
interest rate of 5. How much will you have
next year?

• 100 .05(100)
• 100 5
• 105
• or 100 (1.05) 1

23
Suppose you leave the money in the bank. How
much will you have 2 years from now?

• 105 (.05)(105)
• 105 5.25
• 110.25
• or 100 (1.05) 2

24
How much will you have 3 years from now?

• 110.25 (.05)(110.25)
• 110.25 5.51
• 115.76
• or 100 (1.05) 3

25
1 year from now 100 (1.05) 1 2 years
from now 100 (1.05) 2 3 years from now
100 (1.05) 3

• How much will you have n years from now?
• 100 (1.05) n

26
With an interest rate of .05, n years from
now, 100 dollars will become
100 (1.05) n

• Suppose you put R dollars in the bank with an
  annual interest rate of 5. How much will you
  have n years from now?
• R (1.05) n

27
With an interest rate of .05, n years from now,
R dollars will become
R (1.05) n

• Suppose you put R dollars in the bank with an
  interest rate of i. How much will you have n
  years from now?
• R (1 i) n

28
We have concluded that if you put R dollars in
the bank with an interest rate of i, in n years
you will haveR (1 i) n .

• An alternative way of writing this information
  emphasizes the present and future aspects.
• Let PV be the current or present value that you
  are putting in the bank now and FV be the future
  value that you take out later. Then, we have

29
Present Value
30
Present Value (PV)

• calculated by discounting, which is the
  opposite of compounding
• also called Present Discounted Value (PDV) or
  Net Present Value (NPV)

31
Suppose you are going to receive R dollars at
some time in the future.

• The PV of that R dollars is the amount you
  need to put in the bank today, to receive the R
  dollars n years in the future, if the interest
  rate is i.

32
If the annual interest rate is 5 and you want to
have 100 next year, how much do you have to put
in the bank now ?

• PV 100 / (1.05) 1 95.24

33
If the annual interest rate is 5 and you want to
have 100 in 2 years, how much do you have to put
in the bank now?

• PV 100 / (1.05) 2 90.70

34
1 year 100 / (1.05) 1 2
years 100 / (1.05) 2

• If the interest rate is 5 and you want to
  have 100 in n years, how much do you have to put
  in the bank now?
• PV 100 / (1.05) n

35
If the interest rate is .05, to get 100 in n
years, we need to put in the bank now
100 / (1.05) n

• If the interest rate is .05, to get R dollars
  in n years, how much do you have to put in the
  bank now?
• PV R / (1.05) n

36
If the interest rate is .05, to get R dollars in
n years, we need to put in the bank now
R / (1.05) n

• If the interest rate is i, to get R dollars in n
  years, how much do you have to put in the bank
  now?
• PV R / (1 i) n

37
We have concluded that if the interest rate is i,
to get R dollars in n years, the amount you
need to put in the bank now is

• Since, in this case, the R will be received in
  the future, lets rewrite it as future value FV.
  Then, we have

38
Notice the similarities between our compounding
and discounting formulae.

• Compounding

Discounting
These formulae are actually equivalent, and one
can be derived from the other simply by
multiplying or dividing.
39
Stream of Income How much should you put in
the bank now, with an annual interest rate of i,
in order to take out FV1 one year from now,
FV2 two years from now, and FV3 three years
from now?

• PV

40
Stream of Income How much should you put in
the bank now, with an annual interest rate of i,
in order to take out FV1 one year from now,
FV2 two years from now, and FV3 three years
from now?

• PV FV1 / (1 i)1

41
Stream of Income How much should you put in
the bank now, with an annual interest rate of i,
in order to take out FV1 one year from now,
FV2 two years from now, and FV3 three years
from now?

• PV FV1 / (1 i)1 FV2 / (1 i)2

42
Stream of Income How much should you put in
the bank now, with an annual interest rate of i,
in order to take out FV1 one year from now,
FV2 two years from now, and FV3 three years
from now?

• PV FV1 / (1 i)1 FV2 / (1 i)2 FV3 / (1
  i)3

43
The present value of an amount of money received
(or paid) now is that same amount of money.

• example
• The PV of 100 received now is 100.

44
The PV of future income increases

• when the interest rate decreases.
• when the amount of income received increases.
• when the time the income is received is closer to
  the present.

45
Present Value of an Annuity

• An annuity pays a fixed amount R every year from
  now on into the future.
• The present value of an annuity paying R dollars
  every year with an interest rate of i is
• PV R / i

46
How do you determine whether you should make an
investment?

• Compare the present value of the benefits with
  the present value of the costs.

47
gt
If
PV(benefits)
PV(costs)
INVEST
48
lt
If
PV(costs)
PV(benefits)
DONT INVEST